Problem 1
Consider the following information:
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Stock A
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Stock B
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T-bills
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Beta
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0.6
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1.2
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0.0
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Expected return, %
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5.0
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8.0
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2.0
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- Assuming that all stocks are priced correctly according to the CAPM, compute the expected return on the market portfolio.
- Stocks are generally regarded as being risky investments. According to the CAPM, is it possible for a stock to have an expected return that is less than the risk-free rate? Explain.
- Is it possible for a stock to have a negative standard deviation in returns? Explain.
- Consider two separate stocks: the returns on the stock of AppleCo have a standard deviation of 32% and a beta of 0.9; the returns on the stock of BananaCo have a standard deviation of 20% and a beta of 1.2. Which company's stock should provide a greater return to investors? Why?
Problem 2
Consider the financial statements below for Media Motors. The firm's cost of capital is 10%. The firm is stable, and the long-term growth rate for all items is expected to be 4%. Their CEO's name is Ray Charles. Use the information below to estimate the fair market value of MM's equity as of year-end 2013.
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2013 Income Statement
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Sales
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500
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Cost of goods sold
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250
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SG&A expense
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50
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EBIT
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200
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Interest expense
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40
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Taxable income
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160
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Taxes
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64
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Net Income
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96
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2012 Balance Sheet
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Cash
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50
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Accounts payable
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70
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Accounts receivable
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100
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Total current liab.
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70
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Inventory
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200
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Total current assets
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350
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Long-term debt
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400
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Gross fixed assets
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1,000
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Common stock
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200
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Accumulated depreciation
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200
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Retained earnings
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480
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Net fixed assets
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800
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Total equity
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680
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Total
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1,150
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Total
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1,150
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| |
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2013 Balance Sheet
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Cash
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70
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Accounts payable
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100
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Accounts receivable
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130
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Total current liab.
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100
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Inventory
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220
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|
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Total current assets
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420
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Long-term debt
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450
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|
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Gross fixed assets
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1,120
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Common stock
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250
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Accumulated depreciation
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270
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Retained earnings
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470
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Net fixed assets
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850
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Total equity
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720
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Total
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1,270
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Total
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1,270
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| |
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Problem 3
(a) Arbitrage Financial is offering an investment with the following cash flows:
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Year
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1
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2
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3
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4
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Cash flow
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$200
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$400
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- $100
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$500
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(note that the cash flows in Years 1, 2, and 4 are positive, and the cash flow in Year 3 is negative.)
You observe the following prices of pure discount (i.e., zero-coupon) bonds, which pay a single cash flow of $100 at maturity:
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Price, $
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Maturity, years
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95.24
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1
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89.85
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2
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83.96
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3
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77.73
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4
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What is a fair price (to the nearest dollar) for the investment from Arbitrage Financial?
(b) Arbitrage Financial offers another product called a "mystery coupon" bond. This bond has a face value of $1,000 and a maturity of five years. The bond pays an annual coupon, but the amount of the coupon is unknown. However, you know that the price of the bond is $1,052.30, and bonds of similar risk and maturity currently have a yield to maturity of 6.25%. What is the annual coupon payment (to the nearest dollar) on this bond?
Problem 4
The American Movie Company has the following sources of financing reported on its balance sheet:
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Liabilities & Equity
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Book Value
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Debt (13% coupon bonds, $1000 face value)
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$4,000,000
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Common stock, 100,000 shares
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$6,000,000
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Total
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$10,000,000
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The bonds are currently selling for $900, and have a yield-to-maturity of 15%. The common stock is currently priced at $70 per share, and has an estimated beta of 1.5. The current risk-free rate is 6%, and the expected return on the market portfolio is 16%. The company pays taxes at the rate of 40%.
Compute the firm's weighted average cost of capital. Where calculations are required, please show them in the table below.
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Cost of
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Estimated weight of
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Debt:
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Debt:
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Common stock:
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Common stock:
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WACC =